Equity trading

Going broke in stocks

Trading equities is barely profitable these days, but many banks are carrying on regardless

IN APRIL 1859 a revolution of sorts swept through Paris, or at least its bourse. At the instigation of the market’s regulated brokers, about 20 unlicensed stockbrokers (coulissiers) were arrested and had their papers seized. But the blue-blooded agents de change of the Paris Bourse found themselves under attack from their clients, who wanted to continue to do business with the unlicensed brokers. Not only were they cheaper, but they could take risk and make markets instead of simply matching buyers and sellers. “The affair caused such a commotion that the government got frightened,” a correspondent reported at the time. Within days the unregulated brokers were freed.

Scraps between well-heeled established brokers and enterprising interlopers are as old as trading markets themselves, but competition in share trading has probably never been as fierce as it is today. Since 2007 the revenue generated by trading shares has fallen consistently in every year bar one. Equity trading, once a mainstay of investment banking, now makes up less than a fifth of the industry’s revenue and an even smaller share of its profit. Its relegation is partly due to the spectacular rise of banks’ FICC (fixed income, currencies and commodities) businesses, which have become their most profitable parts.

Yet equities are the canary in the coal mine. The fall in the sector’s trading volumes and the relentless squeeze on margins, revenues and profitability augur badly for large parts of banks’ debt businesses. Five years after the financial crisis, share trading is barely covering its cost of capital. Its investors would do better putting their money in the bank than buying shares in it.

Not buying, not selling

The global financial crisis, the recession in Europe and worries over the euro zone and America’s fiscal cliff have greatly reduced companies’ appetite for takeovers and mergers and for issuing debt or shares for expansion. Most institutional investors, too, have preferred to sit on their hands. Since the financial crisis average share volumes traded in America, still the world’s biggest equity market, have fallen by about 37%. One reason is economic uncertainty; another is that investors are shifting their money from active fund managers, many of whom trade shares furiously in the hope of beating the market, to passive investments such as simple index trackers, which buy and hold an underlying basket of stocks to match the market’s movements.

The most disruptive of these may be the humble exchange-traded fund (ETF), a kind of mutual fund that can itself be traded as a share. This has grown explosively over the past few years. McKinsey reckons that the value of assets in exchange-traded products (defined somewhat more widely than ETFs), which in 2010 was about $1.5 trillion, will more than triple by 2015.

Equities businesses are also facing strong pressure on margins. JPMorgan Chase’s Mr Dimon notes that 30 years ago it cost an average of 15 cents to trade a share; in 2011 the same trade would have cost about 1.5 cents. The pace of change is accelerating as deregulation has allowed stocks to be traded across many different trading venues, as well as in secretive “dark pools” set up to allow the anonymous exchange of large blocks of shares. New technology, too, has played its part as trading has shifted from people to computers. Algorithmic trading and high-frequency trading (HFT), virtually unknown until about six years ago, now account for almost 70% of the flow of orders on the main exchanges.

The rise of HFT and algorithmic trading has improved liquidity in most big and highly traded stocks as well as in frequently traded currency pairs in foreign-exchange markets. Spreads between the buying and selling prices of a share have narrowed considerably (see chart 1). The advantage has shifted from brokers or banks with fast-talking salesmen and traders to those with the fastest computers and the best algorithms. “It’s computer against computer,” says Paco Ybarra, the global head of Citi’s markets business. “It’s basically an arms race.”

This war of the machines is fundamentally altering the distribution of profits and revenues within the industry. Under the old model of employing human traders, some would be excellent, some poor and most average, so they would generate average earnings. With algorithms and high-speed trading the stakes are higher because the fastest computer, or the one with the best algorithm, can take a disproportionate share of trading profits.

Technology has had a curiously contradictory effect on the trading of shares and derivatives. On the one hand it has lowered barriers to entry, allowing for the creation of new electronic entrants and market-makers such as America’s Getco and Europe’s Optiver. These have undoubtedly helped reduce spreads and increase the volume of shares traded. Yet not everyone is convinced that this liquidity is helpful to big institutional investors. BlackRock, a huge asset manager, frets that much of it is “phantom liquidity” that quickly evaporates when investors try to buy or sell significant numbers of shares, usually known as “blocks”. Being able to trade big blocks is important for asset managers because they may want to raise or lower their stake in a company without affecting prices in the market or tipping off their competitors. In a recent report BlackRock said that trading in blocks consisting of 10,000 or more shares in a single company now makes up less than 7% of the total trading volume of S&P 500 companies, down from nearly 50% in the early 1990s.

Much of this decline is due to the widespread adoption of algorithmic trading. If specialist electronic market-makers and high-frequency traders can dice blocks of shares into hundreds of tiny trades that they scatter around the market, so can institutional investors. Yet part of the reduction is because most banks are allocating less capital to equity trading and are less willing to take on the risk of trying to move these big blocks. That reduces their opportunity to earn juicy spreads rather than modest commissions for carrying out the basic paperwork or trading. “Banks and brokers are our partners,” says Richard Prager, global head of trading at BlackRock. “We need their liquidity, their intellectual capital and their products, but if we have to take the execution risk, then the market tips to an agency model where we pay a commission and not a spread.”

The greater a bank’s market share, the better it is able to sense shifts in the mood of the market

The challenge for investment banks, then, is to be able to take on execution risk from clients but without having to dedicate too much capital to it. Here again it helps to have a large share of the market. The greater a bank’s market share, whether it is trading bonds or currencies, the better it is able to sense shifts in the mood of the market and the more easily it can match buyers and sellers. That gives it an advantage in working out how risky a bespoke transaction might be, for instance, if a fund manager asked it to sell or accumulate a large block of shares without tipping off the rest of the market. And the more trading a bank does, the more it is able to invest in better and faster systems. The share of equity trading controlled by the five leading banks (Goldman Sachs, Morgan Stanley, Credit Suisse, JPMorgan and Bank of America) has increased by about one percentage point each year for the past few years, reckons Matt Spick, an analyst at Deutsche Bank. Estimates of the total for the five vary somewhat: Mr Spick thinks it is at around 44% but Brad Hintz, an analyst at Bernstein Research in New York, puts it at about 49%.

Pity the bit players

Smaller banks are struggling to cover their fixed costs and are more likely to misjudge risk. “If you’re a top three player you can probably achieve a cost-to-income ratio of 85%” (about the minimum to be profitable), says Kevin Buehler of McKinsey. “If you’re not top three it is very hard to make a positive return given what you have to spend on technology to stay current.”

Since few firms are making money trading equities, why are so many still in the business? Many heads of investment banking are hoping for a rebound in markets and think they can hold on without allocating huge amounts of regulatory capital to the business. If it bounces back it will offer high ROEs, and if not, well, that will be their successor’s problem. Yet banks’ reluctance to close down businesses that are not profitable “keeps decent industry-level returns as remote a prospect as ever”, says Deutsche Bank’s Mr Spick.

“How long are my competitors going to keep investing in businesses where they shouldn’t because they still have an expectation of world domination?” asks the boss of one universal bank, suggesting, naturally enough, that others should be cutting back, not him. To be sure, cutting back is not without its risks. Some bankers say they want to keep their equities-trading businesses because they are intertwined with and complementary to other things they do, such as offering advice on mergers or helping firms raise debt and sell shares. They fear that if they start unpicking the loss-making parts, their entire operation might unravel. “If you go back in time, no one really exited anything,” says Jamie Forese, the head of Citi’s institutional-clients group. “People worried that if you limited your geographic reach or product spectrum you’d poison the rest of your ambitions.”

UBS, for instance, has sharply scaled back the debt side of its business but is still determined to stay in equities, without which it would lose ground in wealth management. Even cutting costs within the equities business is difficult. Take the dilemma over what to do with equity analysts. Providing first-rate research on stocks is one of the few ways in which investment banks can gain big institutional investors’ attention. Corporate clients are also more likely to turn to a bank for advice if they think its analysts understand their industry.

But good analysts are expensive, and large stocks may be followed by as many as 40 of them, so it is hard for them to stand out from the crowd. Their pay has come down as investors are trading less and squeezing commissions. Investment banks’ research departments also face competition from boutiques such as Autonomous Research, which charges investors a subscription instead of getting paid through trading commissions.

So most brokers are quietly cutting down on the quantity or quality of the research they produce, perhaps by having fewer analysts and getting them to follow more companies. “Research analysts are probably working harder than they’ve ever worked, and are earning the least they’ve earned in at least the past 15 years,” says Simon Hayes of Odgers Berndtson, a headhunting firm. Others are reducing the number of companies and industries they follow.

One way of making research pay is to combine it with providing investors with high-level access to companies. Yet the conferences and road shows at which fund managers can meet companies are becoming commoditised, and regulators frown upon them. Earlier this year Britain’s Financial Services Authority said it would take action against asset managers that rewarded investment banks for arranging meetings with company executives. Many of the executives themselves are also disenchanted when they realise that they are the product the investment bank is selling. “They’re no more than a high-end logistics service,” says the head of investor relations at one large company. “They get me good rates on hotels and send a limo to the airport to collect me.”

Some banks are now starting to question whether they want to stay in this business. “The days of having 20 firms all saying they wanted to be the top three are over,” says Bob Gach of Accenture, a consulting firm. Royal Bank of Scotland closed its equities business in 2012, and Nomura, which had bought the Asian and European businesses of Lehman Brothers in the middle of the crisis, last year retreated from equities trading in some markets. Others are sharpening their focus. Barclays, which had bought the American bits of Lehman Brothers, is cutting back in several areas of its investment bank.

All this would be bearable if other parts of the industry were expanding. But investment bankers face an even steeper drop in revenues and returns in an area which in recent years has been the beating heart of their business: the trading of bonds, currencies and commodities.